Bronte Capital

Saturday, August 12, 2017

As the world knows by now James Damore was fired from Google for writing a memo that questioned Google's diversity policies.

As a holder of Google stock I have a few thoughts on this.

Software engineering is a job where you cannot replace one brilliant software engineer with six adequate ones. It really is a job where the best people can lever their work over millions of computers and the whole world.

If you are Sundar Pichai (the CEO of Google) your job is to attract, hold, motivate and direct the very best software engineers - and to make sure their work does scale over the whole world.

In doing this he literally should not care whether men are better software engineers or mathematicians on average than women. Google should not interested in average. Google should be interested in the best.

I will hold Emmy Noether up as better than pretty well all men in all current mathematics and physics faculties. There may be a dozen in the world who can match her. Probably less. If she pops along you should hire her. Even if women are less good on average at maths than men that should not matter. Emmy Noether is clearly better than anyone else you are going to hire this year.

The truth or falsity of James Damore's assertions in the memo literally do not interest me and should not interest Sundar Pichai. His memo made his job of hiring the the best harder. If the best happened to be a woman or another minority they might prefer work somewhere more welcoming.

If I were the Google CEO I would not have just fired James Damore. I would have been proud to fire him.

There is a lot of talk about Mr Damore receiving compensation from Google for his firing. For what? He broke the Google code of conduct and was fired for cause.

Yes, his feelings and the feelings of many delicate petals on the right are hurt.

But they are no more entitled to compensation for hurt feelings than anyone else.

If Sundar Pichai wastes shareholder funds compensating him I will be disappointed.

And don't think for a moment that this is a liberal line. Google is and should be a proudly elitist place for a software engineer to work. And Mr Damore was fired because he offered a phoney elitism (based on gender rather than competence).

Phoney elitists like him don't deserve to work in such a place.

Mr Damore was right on one thing. Diversity shouldn't be valued for its own sake in such a place either. But I haven't noticed a lack of elitism in Google staff I have met. They positively drip elitism.

Diversity is valued though and it seems is valued for the right reason. It gets you a better chance of recruiting the best.

Thursday, August 3, 2017

I think I know what this means but as per usual the internet is full of people who know far more than me. You dear readers are my 20 thousand person expert network.

This is from the Pioneer Natural Resources conference call. I would really love people to explain it - preferably word-by-word in the comments. In particular I want to understand the drivers of the pressure changes (which matters for proppants for instance) and how the four-string casing deals with the problem.

Thanks in advance:

We've mentioned this in all the slides and such, but we did fall behind operationally on our completions in the Spraberry/Wolfcamp, in large part due to unforeseen drilling delays. What happened is the delays were really the result of unexpected changes in pressure regimes in the field.

So what we've seen is increasing pressures in some of the shallow formations that means we have to mud up substantially to deal with that problem and then we immediately then are drilling into lower pressure depleted zones. And we were at the knife's edge of this really through all 2016. But these pressures have changed in a subtle manner such that we now find we had a higher percentage of what we refer to as train-wreck wells, where we have all kinds of problems with lost circulation and other issues because of this pressure change.

The easiest way to remediate this is with a drilling plan takes us from a three-string casing design to a four-string casing design. So that's exactly what we've done. We solved this issue. We have addressed it and we've done so by changing the casing design, which has proven to be very successful.

One thing it does is it does increase the well cost substantially, about $300,000 to $400,000 per well, and it does increase our time of drilling five days or so. But we're also nickel-and-diming away other costs in these wells to try to get that money back, including changing out surfactants and other things to try to reduce costs and reduce days. So we're not going to stand pat with this increase. We're going to chip away at it and reduce it.

Cumulatively, though, what happens is because we've impacted the schedule, we've also then reduced the number of POPs we're going to be completing this year by about 30. Those essentially will move into 2018. That's 100% due to these drilling delays I mentioned, which I believe we now have mitigated. But you have to also factor in the delays not only result in the deferral of wells you put on production, but also loses production days for all the wells that get delayed that are going to be POP'd in the future, particularly later in the next year. But the point is we're now dealing with that. I think we have that squared away. I have a later slide we'll talk about more detail on that.

Tuesday, June 13, 2017

Regular readers of this blog will be aware that Home Capital Group - a Canadian non-standard mortgage lender - is in financial trouble.

The gossip is that the regulators in Canada are also putting some pressure on lenders to improve underwriting standards. There is similar gossip in Australia, however Australia has not had the collapse or near collapse of any lenders.

Canada Mortgage & Finance Group (CFMG) is a broker in the Greater Toronto Area (GTA). The CEO of CFMG (Ameera Ameerullah) writes a blog on LinkedIn which I have been reading for some time.

She has recently posted about the state of play for even slightly non-standard mortgages in the Greater Toronto Area.

Below (and without further comment but with her permission) I reprint her latest post.

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CLIENTS ARE STUCK AND BROKERS SCRAMBLING - WHAT IS THE GOVERNMENT DOING?Private lending rates increased and lending fees increased with LTV being decreased! Clients are stuck and brokers are scrambling to find options for their clients. Clients are placed in a very bad situation as they are in position of being sued since they cannot come up with the extra capital to close on alternative mortgages.THE GOVERNMENT has caused tremendous issue for clients and the brokers community. We need Home trust back in the market. Presently no one is qualifying with the banks due to increased CMHC premium, lending restrictions and lenders requirement...it's killing clients not helping them!Clients been saving for their down payment and closing cost but now they cannot close on their purchase due to down payment requirement and lending restrictions. Qualifying rate and amortization cut back on insured deals is causing greater concern. Most B lenders are affected with what's happening with Home Capital. Both the residential and commercial market is affected.Private first residential mortgage in the GTA is now at 8.99 to 9.99% RATE - 65% LTV to 75% LTV. You'll obtain 80% if you're lucky and be prepared to pay higher rate and fees. Fees are 3 to 4% on a first now on private - This is INSANE. In fact many private lenders are out of capital. Options are minimum! These changes only affects clients and everyone having a tough time to close. Brokers are scrambling now to find alternative option for their clients since Home Trust is not funding and many other lenders who depended on Home trust money are stuck as well. How can a broker get by when they have to place their clients in an expensive private mortgage? There's no room for us to charge a fee so pretty much we are all affected. Only the big banks are benefiting from the Government change and yet they themselves are loosing business as no one can fit their qualifying requirements. Banks are pressuring their BDM to originate business - how can they when the Government ridiculous change affects the entire mortgage industry? Originating business is easy but closing deals have become horrid and clients pocket is feeling it.The Government really need to make some immediate change as they have in the past year because with this trend home buyers are being placed in more debt as cost of borrowing on private capital is expensive. These changes are hurting clients and will hurt the economy. AWFUL STATE THE INDUSTRY IS IN. If one doesn't have about $1600 - they cannot live in a decent one bedroom apartment even by renting. Clients that purchased from builders and are set to close are having a difficult time to close in allocating extra funds.Brokers should start to voice their opinion as this is our industry and if you don't speak up then we are all doomed with our clients!

Some of the story was obvious - for instance how Chinese students are coopted to drown out rallies by Falun Gong or other opponents of the CCP. A typical story involves a CCP figure visiting Australia, a bunch of human rights rallies and hundreds of Chinese students bussed to the rally with the intention of overwhelming regime opponents.

A Chinese student involved in organising these rallies was interviewed. She made it clear that the embassy helped. Moreover it was clear there was social pressure (or worse) on students to conform - and that non-conformity had a negative effect on the family back home.

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But the more interesting part of the story was how these sudden billionaire Chinese businessman (including businessmen who hung out with spies) were giving large donations to Australian institutions and thus getting close to politicians. (Universities were recipients as well as political parties...)

The implication was that Bob Carr (and his institute) was in some sense compromised.

====

I have always liked Bob Carr. He was the New South Wales Environment Minister when I was in my twenties - and I thought he was great. I still do.

So when invited to attend a talk sponsored by ACRI I jumped at the chance. Ignoring the usual advice that it is not a good idea to meet your heroes (especially if they are politicians) I rocked up full of excitement.

Here is the flyer...

When I got there I got a fabulously naïve talk about how various Chinese businessmen making huge waves in Australia were independent businessmen and not in any way arms of the Chinese government. (This includes people who were trying to buy ports near military bases in Northern Australia.)

The naiveté was amazing. Some of these newly minted billionaires career went roughly as follows:

a). Follow dad into the Peoples' Liberation Army (where he is a senior general)

b). Retire in your twenties

c). Start an import/export business. Make a quick 15 million.

d). Invest that in a huge land business. Turn that into a quick billion.

e). At the age of 35 turn up in another country and throw half that money round buying strategically important assets.

But these businessmen were in no way affiliated with the CCP.

Whatever: I left thinking I was born on a Monday - but not last Monday.

(But I was well satisfied with the drinks and canapés...)

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Anyway Bob Carr is in The Australian (Murdoch's national newspaper in Australia) dissing the whole Four Corners story. You can read his defence. It didn't go very near how his own organisation might or might not be compromised.

But as he hasn't I thought I might just put the document circulated that night up for all to read. Maybe the China experts here can tell me whether this is merely naïve (which would be my normal guess) or directly paid for by the CCP.

As Bob Carr has chosen Murdoch's network to defend his benefactors maybe I should just end with the most famous News Corp slogan: I report, you decide.

John

Post script:

I should note that I am in no way opposed to Chinese billionaires (even if they are CCP linked) investing their loot in Australia. In fact I would encourage it - and can probably suggest some fine ways of investing it.

I just think a ninety minute seminar suggesting a string of Chinese billionaires don't have powerful ties to the CCP is - well quaint at best...

Monday, May 15, 2017

Last night I had dinner with a friend who had a friend who was buying Valeant. Whatever - it led to a discussion of Valeant fundamentals - and that in turn led to this blog post.

The stock has been on a tear lately - rising from $10 to $13.59 in the last week - poking above $14. To some degree this is just standard volatility for a bombed out stock. But it was prompted by Valeant producing results with a sharp rise in "adjusted EBITDA" and guiding for higher adjusted EBITDA. As the FT put it Valeant "bumped guidance".

The Valeant adjusted cash flow caperI want to explore this "adjusted EBITDA" number. Then I want to lay out the valuation directly.

Valeant has a history of producing little or no GAAP earnings but very large adjusted cash flow. The adjustments are after a collection of exceptions chosen by management and not subject to audit. This blog has demonstrated in the past that some of these exclusions from cash flow are recurring expenses. That said here is the history going back to the final quarter of 2012.

*In the fourth quarter of 2015 the company presented a late annual report. It announced preliminary earnings that contained a new measure: "adjusted EPS". The "adjusted EPS": was not reconciled in any way to previously announced "adjusted cash flow". The "adjusted earnings" in the above table are is the total adjusted earnings that was used to calculate the "adjusted EPS".

**In the first quarter of 2016 the company reported an adjusted EPS number and and adjusted EBITDA number started guiding for an adjusted EBITDA number. You would think this number to be broadly consistent with previously used "adjusted operating cash flow" numbers. It wasn't. Remarkably there was an unexplained mismatch between the 2015 first quarter adjusted EBITDA number and the originally reported "adjusted operating cash flow". The old number was 708 million as in the above table. The new number was 1127 million. Somehow as Valeant was collapsing they surreptitiously changed their adjustment to even further increase their stated adjusted cash flows.***In the second quarter of 2016 the company reported an "adjusted net income" which was inconsistent with previously reported numbers. The previously reported number was "adjusted operating cash flow" of $773 million in the second quarter of 2015. Now they reported "adjusted net income" of $751 million for the same quarter. I cannot reconcile the old $773 million number to the new $751 million number.#In the third quarter of 2016 the company produced an "adjusted earnings" and adjusted EPS number. There is a number for adjusted earnings in the previous corresponding period (that is the third quarter of 2015). That number is $845 million. Again I cannot reconcile this number to the previously stated number.

##In the fourth quarter of 2016 the same issue arises but this time with respect to adjusted EBITDA which is now reported as $1374 million in the fourth quarter of 2015.

###In the first quarter of 2017 the adjusted EBITDA presented for the first quarter of 2016 was $1008 million. Again it cannot be reconciled to the previously reported $1076 million.

Huge cash flows - company is on its knees

Its pretty obvious here that the "adjusted" numbers need to be taken with some salt. Firstly the adjustments simply do not reconcile quarter on quarter. Secondly despite all these adjustments GAAP earnings look limp and the company is on its knees.

In the last quarter the GAAP earnings look fine until you realise that more than 100 percent of them come from writing down previously accrued deferred tax liabilities. The earnings are good because the company won't be paying as much tax in the future (possibly because losses are large and unrecoverable).

The headline: guiding up non GAAP adjusted EBITDA

That said the headline for the Valeant numbers were that they bumped up guidance for their own non-GAAP measures. (They do not and never have guided GAAP numbers.) Here is the key text:

Valeant has raised guidance for 2017, as follows:

2017 Full Year Adjusted EBITDA (non-GAAP) in the range of $3.60 - $3.75 billion from $3.55 - $3.70 billion

This guidance reflects the impact of the sale of the CeraVe, AcneFree and AMBI skincare brands. This guidance does not reflect the impact of the sale of the Dendreon business, which is expected to close mid-year.

What this does not state is that they missed previously announced revenue guidance - and missed it quite badly.

This was the previously announced guidance (announced with the fourth quarter 2016 results):

But in the first quarter revenue came in at $2.109 billion. That is a really big drop. You would have to think that Valeant is going to miss its annual earnings guidance by $500 million or so. The FT article notes an 11 percent decline in revenue.

The common sense test

I am an old fashioned sort of guy. There are really only two ways you can raise real EBITDA (and hence I would think that there are only two ways you can raise adjusted EBITDA).

The first way is you increase revenues.

The second way is you decrease costs.

I think that is the end of the story.

So Valeant revenues are on track to miss guidance by about half a billion dollars. But they are going to beat their adjusted EBITDA number.

This can only be done if they have decreased their costs by an unanticipated half a billion dollars.

Possible: but I would like to know what costs they are cutting that they had not previously anticipated.

Remember this is a company that was notorious for cutting costs (possibly to excess) whenever they purchased an asset.

This was the company who fired almost all non-revenue producing people.

Scientists doing research: fire them.

Compliance officers: fire them.

So I am left with a choice. Either

The entire myth of Valeant - that it was a ruthlessly low cost operation is bullshit and there are still plenty of unanticipated costs to cut allowing the company to miss on revenue and beat on adjusted EBITDA, or

They are cutting hard into revenue producing staff, but this is going to raise adjusted EBITDA or

The adjusted EBITDA number and guidance is BS.

As you can guess common sense leads me to the third choice. The adjusted EBITDA number and guidance remain BS.

Alternative valuation measures

You can't value this company against the "adjusted EBITDA" because - as this post demonstrates that number is almost certainly BS.

You can't value this company against earnings because (other than writing off future tax liabilities) this company has no earnings.

So you are left trying to value it against revenue.

So lets play this game.

Let's presume that Valeant revenue is as good as Gilead revenue. Gilead is of course the super-champion drug company with $90,000 drugs that cure nasty diseases like Hepatitis C. It is one of the finest drug companies in the world - and is strongly profitable.

Assuming that Valeant's rag-tag of declining generic drugs with increasing competition is - per dollar of revenue - as good as Gilead - is of course generous.

But lets assume that...

Gilead Revenue is running at $29 billion per annum. The revenue is declining though because the drug works - and people are being cured of Hepatitis C. The market cap is 86.3 billion and cash and equivalents are 11.9 billion. The enterprise value is just under 75 billion - so this is worth just over 2.5 times sales.

If you project pretty gnarly falls on Gilead Revenue (simply because their drug works) it is hard to get below 3 times sales for Gilead.

Valeant sales are about $8.4 billion. Put that on three times sales and you can't even cover the debt. The equity will wind up being worth a brass razoo.

--

Now I am being harsh. Growing pharmaceutical companies with franchises and new drugs in the pipeline regularly trade at 4.5 times sales. If you put Valeant on 4.5 times sales you something in the mid 30 billion range - but only if Valeant sales rapidly stop their catastrophic decline.

Valeant debt is about 28.5 billion. That gives you potentially - and this is if everything goes right and you put it all on a pretty decent multiple of revenue - about $7 billion in residual equity value. The market cap is about 4.7 billion now.

So if all goes really well you can make some money. But you need to make some pretty heroic assumptions.

Firstly you need to assume that the various litigation that is inevitable doesn't impair that too much. (I think it will...)

Then you need to assume that the revenue doesn't continue to fall. (I think it will. The company will not be allowed to charge over $200 thousand per year for drugs like Syprine indefinitely. There is probably half a billion to a billion in revenue that will go away simply as competition hits the massively overpriced generics. Actually half a billion is generous.

On top of this you have to ignore the inevitable competition that will come to their biggest drug (Xifaxan). That drug will have a generic supplied by Allergan.

All up I forsee well over a billion dollars of likely revenue declines.

Finally you have to ignore the lack of integrity that allows you to guide up "adjusted EBITDA" when the revenue misses by a lot and where you have not obviously cut costs.

Still - if this is the gamble you want - good luck to you. There are easier ways to make money.

Wednesday, May 10, 2017

Several people on twitter and some in person have asked me for an update on my very bullish position on Verizon - especially since the results were not as good as expected last quarter.

I promised I would be forthcoming - but that I wanted to spell it out to our clients first. This is an extract from a client letter.

I want to start with the original bull thesis.

The original thesis

The original thesis came from watching Randall Stephenson (the CEO of AT&T) talk at a Milken Conference in 2012. The original recording is here. The relevant portion of the video starts at about minute 18.

Randall Stevenson tells a story of the iPhone’s introduction. The introduction of smart phones ran the company out of capacity in parts of country. [Apple offered the iPhone exclusively through AT&T in the USA.]

In New York the problems were intense. The complaint in New York was that the iPhone was a great phone so long as you accepted you could not use it as a phone. Jon Stewart mocked the coverage with unusual brutality on the Daily Show (link).

AT&T solved this by more and more capital expenditures. At the time, capex ran at around US$20 billion per annum. AT&T was – other than the government – the single biggest capital spending entity in the US.

Stephenson (speaking in 2012) said that the same problem would recur as usage continued to grow massively. But this time Stephenson argued it is different. He asserted that AT&T would not be able to solve this problem by more capital equipment. Spectrum congestion was inevitable.

He saw this as apocalyptic, but we saw potential pricing power and improving profitability.

We were doing simple arithmetic and getting very large numbers. Most Americans if given a choice between their pay-tv provider and their smart phone would choose the smart phone, but they currently pay more for their pay-TV.

We figured that if there were a shortage of capacity then the phone companies would get a lot of pricing power. Our figuring was that with $10-15 per month of extra pricing power Verizon would wind up as a very good stock indeed. And we did not see a reason to stop at $10-15. [It wasn't hard to develop a model where Verizon wound up worth more than Apple.]

This of course led us to do a lot of research into telecommunications technology to see if we could verify Mr Stephenson’s claim of inevitable shortage. And as we discovered nothing in this space is ever as simple as Mr Stephenson’s blanket claims.

So – at the risk of offending people with deep knowledge of how mobile telephony works – we are going to give you a crude understanding of the issues. We do it by simple analogy.

Imagine us in a very large room (say a big indoor stadium), you with a receiver and me with a transmitter flashing a red light.

I could flash you a signal. Morse code would do.

With Morse code I could flash things to you at a maximum rate of about five characters per second. That is not very fast.

Alternatively I could use a computer to control my flashing light and you could use a computer to read it.

I could then flash signal to you at about the intensity of a CD player. It’s quite a lot of information. More than enough for you to run the internet at a reasonable speed.

The first and most important way in which we have got more capacity is by using better and better signal encoding and decoding. In mobile telephony, we refer to the generations of transmission technology as analog, 2G, 3G and 4G (namely LTE). It was our assertion that this trend had reached its natural limit.

Now imagine there are 10,000 people in this room. I could flash a signal to all of them with my red light. And if I equipped all of them with a smart decoder (say a little computer built into your phone) then I could flash the signal encrypted – and they could decrypt it, pick out their bit of the signal and discard all the rest of the signal as white noise.

The problem now is that my red-light is shared between 10 thousand people and whilst it is very fast if used for one person it becomes quite slow when used for 10 thousand.

There are multiple potential solutions.

One solution is to beam my red light to every person individually – say using a laser. This is effectively what is done in a fiber-optic cable. The laser in the cable goes to me, and a different laser goes to you, and they are not mixed because they go down different fiber-optic cables. This offers anyone on the end of a fiber optic cable almost unlimited capacity. The problem is that you have to be connected to the fiber optic cable - and we use these things mobile.

There are possibilities of beaming radio-waves to people too, though for the most part this is laboratory stuff, not stuff already implemented by phone companies. [That said – it is said by some that the reason that AT&T wants to buy Straight Path is that their spectrum was good for beam forming.]

Another more realistic solution for most purposes is cell division. Instead of using one big red light to signal everyone in the stadium, I could instead build hundreds (maybe thousands) of small transmitters each beaming a low intensity beam to small groups of people or even individuals.

There is no real limit to the amount of cell division if I make the power of the antenna low enough. That is, in part, what WiFi does. The power of a WiFi transmitter limits its range to about thirty meters. This means my WiFi transmitter does not interfere with your WiFi transmitter because they are more than say sixty meters apart. The amounts of information that can be carried on WiFi is enormous precisely because the transmitters are so low powered and so numerous.

When someone says that they are going to “run out of spectrum” they are in some sense kidding you. One can always produce more capacity by cell division. The only problem is that it rapidly becomes enormously expensive. To cover America with WiFi one would need to build billions of transmitters.

Cell division is expensive. Really expensive.

Then there is another alternative. A cheap one. Just use another colour to transmit. Transmit to one person using red light and someone else using blue light. If my colours are far enough apart on the spectrum chart then they will not interfere with each other.

Using another colour is another word for using more spectrum.

Spectrum is an alternative to cell division and hence capital expenditure.

Spectrum has value if it allows a carrier to avoid capital expenditure.

This leads us to the three ways phone carriers (like AT&T or Verizon) have managed to carry more wireless data:

a). Advances in encoding technology (from 3G to 4G, for instance),
b). More cell division (deploying more equipment) thus shrinking the number of users sharing a single cell,
c). Deploying more “colours”, also known as more spectrum.

We then spent a lot of time researching the limits to each approach, and we focused on spectrum because Randall Stephenson led us there.

Not all spectrum is equivalent. Some can go through walls (low frequency radio). Some cannot (eg visible light). But going through walls is important if I want to use my mobile phone inside.

It turns out that to a rough approximation light can go through an object half its wavelength thick. (The physicists will pick objections to this statement.) But light at 600 MHz will go through the walls of most buildings but light at 5000 MHz (where upper-band WiFi is located) will not.

This makes 600 MHz spectrum much more useful for mobile telephony. It is sometimes called “beach front spectrum” for this reason.

There is a lot of high frequency spectrum available, but it does not have good propagation characteristics. Sprint – the US carrier - is unlikely to ever run out of such spectrum. There is, however, a limited amount of “beach front spectrum” available which has very good propagation characteristics.

Thus the high frequency players like Sprint or T-Mobile in the US tend to offer cheap unlimited packages (because they have a lot of spectrum) but have lousy coverage.

By contrast low frequency players (AT&T and especially Verizon) tend to have limited capacity (as there is limited low frequency spectrum) but great coverage (because it propagates well).

In this sort of market we wanted to own the low-frequency players, as they own what is limited and valuable. But the low-frequency players do not have unlimited pricing power, because customers might jump to high-frequency players offering a cheap – albeit inferior – product.

We purchased positions in shares in low frequency players who we believed would own increasingly valuable spectrum. We figured all we needed to do was wait.

And the data was largely supportive. Verizon Wireless revenue grew quite quickly, even when the fixed line business was declining. Here is a slide of Verizon Wireless revenue from the 2013 Q4 Verizon earnings presentation (slide 7):

You could not see this in the Verizon accounts because the landline business was declining, but our logic was that the landline business would stop declining and the wireless growth would continue.

The thesis was reinforced when very high and increasing prices were paid for spectrum in recent auctions in many jurisdictions in the world.

We went so far as to download from the Federal Communications Commission a list of spectrum ownership by county in the US and match that with the population data from the census. We used spectrum prices that we saw being used by major parties in big auctions. Prices are usually considered in dollars per MHz per head of population. We concluded that Verizon offered the best valuation and that using this model owned $500 billion worth of spectrum. If the spectrum prices that we observed being paid were rational then Verizon in particular was really cheap.

The Verizon position had an additional advantage: the penalty for being wrong appeared low. After all, if we were wrong, then we owned Verizon, a high-dividend paying “grandma” stock.

AT&T’s behavior

One fly in the ointment of our thesis was the continued bizarre behavior of the major carriers – especially AT&T. If the spectrum story was as good as we thought, then if you ran a telephone company you would not dilute your stock under any circumstances. You would largely use spare cash to buy back your stock and would bide your time until the loot flowed in from rising prices.

If you believed Randall Stephenson’s story that is what you would do.

Instead AT&T purchased DirecTV – a large satellite TV company.

At one stage we had a large AT&T position. Their behavior convinced us to sell. Besides Verizon was better on the spectrum valuation model described above.

Still this irked us. Perhaps we were wrong…

The thesis broke

There were several things that, should we observe them, would tell us we were wrong. These were:

a)The price of spectrum at major auctions or major transactions not continuing to rise;
b)Verizon, in particular, or low frequency carriers in general offering increasingly large bundles at lower prices; and
c)Wireless revenue growth slowing.

We were unconcerned about price competition for small data bundles (say 2GB of data per month) because we figured there was enough capacity to offer everyone a few GB of data. But we were very concerned if discounts were offered on large bundles of 10GB or more. Most importantly we did not want to see the reintroduction of unlimited bundles.

Alas our thesis broke pretty rapidly on all three criteria over the past six months. The incentive auction (that is the recent US spectrum auction) produced much lower spectrum prices, Verizon reintroduced unlimited bundles, and revenue growth slowed--and then slowed some more (it is still positive, but only just).

The entire position was sold.

Obviously the engineers at Verizon think they can handle all the extra usage that will be piled on what we thought was their limited bandwidth.

When the thesis is wrong it is time to sell.

How bad could it get

We actually think it could get quite bad at the carriers. The world’s worst business is one with high fixed costs, low marginal costs, and lots of competition. In that case the competitive forces will drive prices down to the low marginal costs – and it will be impossible to recover fixed costs.

When the fixed costs are debt financed, bankruptcy often follows. That is precisely why the airlines have been bankrupt many times. The marginal cost of filling the otherwise empty seat is very low – and competition at times drives prices to those very low marginal costs.

If wireless telephony capacity really is unlimited and the carriers insist on price wars then the future is bleak indeed. (For shareholders, if not for consumers.)

We have gone from thinking the carriers were exceptionally good longs to believing they might be good shorts. We are not there yet: we would like to see falling wireless revenue first. But if spectrum
isn’t truly scarce this could get ugly.

Saturday, May 6, 2017

Apple is a definitively high margin manufacturer. Everything about that company screams high margin.

The stuff feels expensive and (frankly) is expensive. But you are willing to pay for it because (a) it defines your identity and how you feel about yourself, (b) really does work pretty well and (c) has very good ways of keeping competition out - so you can't buy a true substitute.

On top of that Apple has software sales which (typically) are fatter margin than manufacturing.

Let's spell out just how high margin.

Here is Apple's 2017 second quarter results (link). Note these results are unaudited and in millions of dollars.

Reported sales were $52,896 million, Gross Profit was $20,591 million, and Operating Income was $14,097 million.

These are stunning numbers (especially because of their size) but lets spell them out as percentages...

Gross margin was 38.9 percent.
Operating margin was 26.7 percent.

Just stunning numbers.

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At Bronte we have the (justified) view that any manufacturing company with margins fatter than that needs some explaining.

Trex makes decking. Plastic decking. Outside many houses in middle America is timber deck often with a barbecue - or at least a grill - sitting at the end. This is a place for barbecue, socialising and - of course - beer.

The beer is very important.

The deck is also a frustration for owners because exposed to the weather the deck needs to be maintained regularly - and at a minimum oiled every year or so.

Sure the frustration can be offset by more beer. And I guess that makes it okay.

But these days you have an alternative - you can have fake timber decking. The fake timber is made of plastic and the sales pitch is that it looks just like timber but all you need to do for maintenance is sweep it.

Plastic decking is sold as a superior alternative to timber.

There are lots of suppliers. There is Trex Company, Fiberon, Azek and others. Beyond that Home Depot and Lowes have their own house brands (eg ChoiceDek available only at Lowes).

So with plenty of competition for a building product where most people will not know the brand names (and where the purchase is large and so you might wish to shop it) you would expect lowish margins.

But you would be wrong. The margins are stunning.

Here is the last quarterly result (link). This time the numbers are in thousands of dollars rather than millions...

Reported sales were $144,806 thousand, Gross Profit was $65,169 thousand, and Operating Income was $41,900 thousand.

Again we should spell them out as percentages...

Gross margin was 45.0 percent.
Operating margin was 28.9 percent.

Whoa - Trex Company - with lots of competition - is fatter margin than Apple.

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So what is happening here? How the hell does Trex do it?

There is your business puzzle for today.

And if you are a journalist with a middle-America beat there is a great story here for you. This one is just made for the USA Today or non-business mainstream media.

John

Disclosure: short a little Trex (which traded badly on these results).

This is not a death-grip short like say Home Capital Group. But it is a source of some amusement. I like puzzles like this.

Saturday, April 29, 2017

Home Capital Group is an aggressive Canadian home lender that has hit a very rough patch. If you want a history Twitter will do it well. They have been fighting with Marc Cohodes (a very well known short seller) and you will find a timeline of the unfolding disaster by following Marc's tweets. [Disclosure: I have known Marc for 17 years and we are friendly.]

The crisis came this week when Home Capital Group entered into an emergency loan. The press release is here - but the salient points are repeated below.

TORONTO – April 27, 2017 – Home Capital Group Inc. (“The Company” TSX: HCG) today announced that its subsidiary, Home Trust, has secured a firm commitment for a $2 billion credit line from a major Canadian institutional investor.

The Company also announced it has retained RBC Capital Markets and BMO Capital Markets to advise on further financing and strategic options.

The $2 billion loan facility is secured against a portfolio of mortgages originated by
Home Trust.

Home Trust has agreed to paying a non-refundable commitment fee of $100 million and will make an initial draw of $1 billion. The interest rate on outstanding balances is 10 per cent, and the standby fee on undrawn funds is 2.5 per cent. The facility matures in 364 days, at the option of Home Trust.

The facility, combined with Home Trust’s current available liquidity, provides the Company with access to approximately $3.5 billion in total funding, exceeding the amount of outstanding High Interest Savings Account (HISA) balances.

Home Trust had liquid assets of $1.3 billion as at April 25, plus an additional portfolio of
available for sale securities totalling approximately $200 million.

Access to these funds is intended to mitigate the impact of a decline in Home Trust’s HISA deposit balances that has occurred over the past four weeks and that has accelerated since April 20. The Company will work closely with the lender to have the funds available as soon as possible.

This on the face of it is an extraordinary loan. It is secured by giving the collateral and costs something between 15 and 22.5 percent depending on how much is borrowed.

Its also extraordinary because of what it does not mention. It does not mention who the lender is and it does not delineate what the precise capital is.

But we know that this is being used to pay High Interest Savings Balances. We know there is a run on the bank here here and the run is several hundred million dollars per day.

This is desperation financing. They are securing mortgages (average interest rate below 5 percent) to borrow funds that cost 15 percent or more. The negative carry is huge. A financial institution cannot stay in business under these terms.

The stock reacted - dropping 60 percent in a day. The Canadian exchange busted some trades about $8.20 (because it thought that they were done in error). Mine were amongst the busted ones. I was perfectly happy to sell at that price however in their wisdom the exchange thought that mine was a fat-finger trade. [Disclosure - transaction to sell 30,000 shares at 8.19 was reversed.]

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Anyway the next day we found out who the lender was. It was the Healthcare of Ontario Pension Plan (HOOP). This was unusual because Jim Keohane was on the board of Home Capital and also the CEO of HOOP. Likewise Kevin Smith - Home Capital's Chairman - was on the board of HOOP.

The cries of conflict of interest were loud and undeniable.

The next day Keohane resigned from Home Capital's board and Smith resigned from HOOP's board.

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Then (Friday Canadian time) Jim Keohane gave the most extraordinary interview. You can find the whole thing here:

a). The loans are secured by 200 percent of their value in mortgages (which makes the investment almost riskless - and Mr Keohane goes to some lengths to describe how low the risk is), and

b). Me Keohane says the deal is more akin to a "DIP deal". DIP stands for debtor in possession and he is thus saying the deal is bankruptcy finance.

This is an extraordinary position for Mr Keohane to take. He was an insider to both institutions (a true conflict of interest).

What he is saying is that he isn't taking any risk because he has taken all the good collateral and he expects Home Capital go go bankrupt.

And note that he will make 15 to 22.5 percent return (more if the loan is repaid early in a liquidation) whilst taking no risk.

I have two words to say to this: fraudulent conveyance. In a rushed deal (one that truly surprised the market) done with undisclosed insiders up to four billion of the collateral and maybe three hundred million dollars of book value has been spirited away. And at basically no risk the recipient of all this largess.

Wow that was audacious. More audacious than just about anything I have ever seen on Wall Street.

Jim Keohane seems to recognise what he has said because almost immediately he says that he doesn't know what the acronym DIP stands for.

That surprised me: Mr Keohane uses the phrase DIP Financing precisely and accurately and in context and then says he doesn't know what it means. You should note that Mr Keohane is a very sophisticated fixed income player. (If you want a guide to how sophisticated read this...)

The position of the Canadian Government

The Canadian Regulator is put in an extreme bind. Up to $300 million of value has been spirited away from a highly distressed institution.

The regulator however has guaranteed a very large amount of funding of Home Capital (guaranteed deposits). They should be alarmed at up to $4 billion in collateral being spirited away to HOOP. This effectively subordinates the insured depositors and in the event of Home Capital's failure will cost the taxpayer several hundred million dollars.

This is not an idle concern. The funding itself indicates that it is very likely Home Capital will collapse. And a former director described this as akin to DIP Financing.

If I were the regulator

If I were the regulator I would be doing my duty here. My duty here is to protect the taxpayer.

Very rapidly Home Capital needs to find a buyer to assume the government insured obligations. It does not matter if this happens at 20c per share. Indeed from a regulatory perspective it is better if it happens at a low share price because it gets rid of claims of bailouts inducing moral hazard.

If Home Capital cannot find a buyer then it should be liquidated. Immediately. And the transaction with HOOP should be reversed under standard bankruptcy rules for reversing fraudulent conveyance. There is no reason that taxpayers should accept subordination to a loan yielding 15-20 percent.

Indeed regulators have a duty to stop that sort of thing.

John

Disclosure: I am short a modest amount of Home Capital stock so I have a vested interest in its collapse. Canadian taxpayers are on the hook for billions in guarantees. They have a bigger vested interest. Either way this one is toast. But a special sort of toast which allows HOOP to keep all the cream and jam spread.

Also note: this is the first Australian or Canadian mortgage lender to near collapse. That is an important step in the end of the property bubble.

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It is also worth noting that Wikipedia give a standard list of indicators that fraudulent conveyance has taken place. Most appear to be triggered here.

Becoming insolvent because of the transfer;

Lack or inadequacy of consideration;

Family, or insider relationship among parties;

The retention of possession, benefits or use of property in question;

The existence of the threat of litigation;

The financial situation of the debtor at the time of transfer or after transfer;

The existence or a cumulative effect of a series of transactions after the onset of debtor’s financial difficulties;

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.